Exchange-Traded Funds (ETF) are a category of funds which are listed and traded in a stock exchange. Since it trades like a stock, its Net Asset Value (NAV) is not computed at the end of each day like in a mutual fund because ETFs experience price fluctuations throughout their purchase and sale. The underlying assets held by an ETF can be stocks, commodities or bonds, oil futures, foreign currency, etc. The ownership of these underlying assets is divided by converting them into shares. Though shareholders do not directly own these assets, they are eligible to receive a percentage of the profits as dividends or interests. Just like stocks, ETFs units can be purchased, sold or transferred.
ETFs track indexes that can be a bond index or stock index such as BSE Sensex or CNX Nifty but unlike other index funds, ETFs do not try to perform better than their corresponding index. Instead, they mimic the performance of the corresponding index. ETFs are an attractive investment alternative for many investors due to their high liquidity offering and low costs.
Features of Exchange-Traded Funds
- By nature, ETFs are index funds which means the investment is made on an index. However, ETFs offer low expense ratio when compared to an index fund.
- ETFs are passively managed which means that the fund manager does not actively decide which stocks they wish to own.
- ETFs possess a lower tracking error. Tracking error is an indication of how closely the benchmark index is followed by the portfolio.
- The trading value of an ETF depends on the NAV of the underlying assets that they represent.
- The main objective of ETFs is to yield high returns for investors at minimal costs.
Advantages of Exchange Traded Funds
Exchange Traded funds carry several advantages which have contributed to making them one of the most popular types of investment. These funds hold many benefits for investors who may find it challenging to analyze and pick stocks to build their portfolio.
- To allow investors to take advantage of the prevalent price, exchange traded funds allow the offer the ease of making intra-day sales and purchases on the stock exchange.
- ETFs allow investors to not only grab but also utilize possible lucrative trading prospects which may arise during the day by providing funds which closely track performance of an index during the day, which can be bought or sold at any point in time.
- Exchange traded funds are low cost.
- As opposed to listed close-ended funds that usually trade at discounts to NAV, exchange traded funds are planned in a fashion which permits large institutions and authorized participants to generate new units and exchange the remaining units with the fund, hence making sure that the ETFs trade as close as possible to their original NAV.
- The functioning of exchange traded funds function is similar to that of index funds. Here, the redemption / subscription of units functions on the model where exchange is done with underlying securities and not with cash.
- Not only do exchange traded funds feature comparatively lower costs of distribution but also have a significantly wider reach. This can be attributed to the fact that these funds are listed on the stock exchange. As a result, the savings made on the distribution costs are transferred on to the investors by way of lower costs. Additionally, the structure of ETFs helps bring down various other processing related costs of disbursement, collection, etc.
- Since the fund helps keep a check on the extra transaction costs involved in the purchase a of index shares because of regular subscriptions and redemptions, exchange traded funds safeguard long term investors from the outflows and inflows of short term investors.
- Given the fact that they are highly flexible, exchange traded funds may be utilized as a tool to obtain immediate exposure to equity markets.
Types of Exchange Traded Funds
The various types of exchange traded funds (ETFs) are Index ETFs, Stock ETFs, Bond ETFs, Commodity ETFs, Currency ETFs, Actively Managed ETFs, Inverse ETFs, and Leveraged ETFs
Index ETFs - This is the most common type of ETF available today. As the name suggests, this kind of ETF monitors the performance of an index and replicates it. It purchases all the stocks present in the benchmark index in the same proportion and is passively managed hence, incurring lower expenses. Some of the index funds in India are UTI Nifty Index Fund, IDFC Nifty Fund, Aditya Birla SL Index Fund, HDFC Index Fund, SBI Nifty Index Fund, Reliance Index Fund, IDBI Nifty Index Fund, etc.
Stock ETFs - A stock ETF exposes the investors to a pool of equities in a particular sector or index without the need of buying individual stocks.
Bond ETFs - This type of ETF replicates the returns of an index of bonds and are traded on a stock exchange. They feature attractive properties just like equities. Bond ETFs offer many advantages such as diversification, price transparency, ease of trading, high liquidity, and monthly income payout.
Commodity ETFs- This type of ETF invest in commodities like silver, gold, and other precious metals. Gold ETFs are a type of commodity ETF. Many commodity ETFs these days are administering the strategy of futures trading.
Currency ETFs - Gaining exposure to foreign exchange market is the objective behind Currency ETFs. This kind of ETF provides investors with a cost-effective and seamless way to trade currencies during the usual trading hours. They have been designed with an intent to track the behaviour of a particular currency in the foreign exchange market.
Actively Managed ETFs- This is a form of ETF where a fund manager or a team takes decisions on the portfolio of the underlying assets. It does have a benchmark index but the managers are allowed to make changes in the allocations of sectors. Actively managed ETFs have a high expense ratio.
Inverse ETFs - Also known as a Bear ETF or Short ETF, this kind of ETFs are traded on a stock exchange and returns inverse performance of its benchmark index. They function by making use of short selling, trading derivatives, and other investment techniques.
Leveraged ETFs - An ETF that makes use of financial derivatives and debt to magnify the underlying index returns are known as leveraged ETFs. Owing to the high risks associated with it, they are not very often used for investments in a long-term.Risks of Exchange Traded Funds
Exchange traded funds, like any other fund are not free from risks. However, the level of risk involved in an ETF varies with the type of fund and the assets which it has invested in. Some of the risks associated with ETfs are variation of trading price of shares or units, volatility, absence of an active market, and missing benchmark leading to inability of tracking the index.
Mutual Fund investments will be subject to market risks. Any mutual fund listed in the document does not guarantee fund performance or its underlying creditworthiness. Do read the mutual fund document thoroughly before investing. Specific investment needs and other factors have to be taken into account while designing a mutual fund portfolio.
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